What Are Tail Risk Funds? New Investor Study Explains

We have just finished our newest investor study on tail risk funds. You can see an excerpt below (full booklet).

Tail risk funds represent a small niche of the hedge fund industry, and there are a few different types. They essentially serve as insurance for your portfolio. They lose money most of the time, but when there is a tail risk event, they rise quite a bit when the rest of the market crashes down hard and fast.

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What Is Tail Risk?

Tail risk funds hedge against tail risk, which is a type of portfolio risk that appears when there is a significant chance that any particular investment or fund will move more than three standard deviations from the mean. Tail risk events have a small probability of occurring, but they do occur from time to time, which is why many investors choose to use tail risk funds.

Traditional strategies for portfolio management usually follow a pretty normal distribution. There's nothing out of the ordinary with them. However, tail risk funds are able to normalize the returns of an entire portfolio by making up for steep declines when there is a sudden correction with no warning or time to prepare for it. Such a steep, sudden correction occurred in March 2020, and many tail risk funds made headlines with astonishing returns during the selloff.

When a tail risk event occurs, it means the distribution of returns is abnormal. The returns distribution is skewed and has fatter tails, which indicate probability that an investment will move more than three standard deviations. It's important to note that tail risks can move in their direction. Left tail risk is what investors worry about the most because it means their returns are negative, but right tail risk means that investments have moved up by more than three standard deviations.

Left tail risk is what investors worry about the most because it means their returns are negative, but right tail risk means that investments have moved up by more than three standard deviations.

The term "tail" in tail risk is a reference to the end parts of the bell-shaped curve of the probability distribution of events. The left-hand side of the tail refers to the lowest returns, while the right-hand side marks the highest returns.

Distributions And Hedging

Whenever you compile a portfolio of investments, there is about a 99.7% probability that the return will move up or down between the mean and three standard deviations. This is what makes tail events so rare. The possibility of such an event occurring is only 0.3%, so they happen rarely, but they do happen.

Tail events can do serious damage to a portfolio, erasing years of gains in one fell swoop. As a result, many investors choose to hedge against them even though the probability of one happening is only 0.3%. Tail risk funds are one way to hedge against such events. Those who invest in tail risk funds should realize that the part of their portfolio that's in the tail risk fund will lose money 99.7% of the time, which means it should be just a very small part of the portfolio. In most cases, investors who buy into tail risk funds make them less than 5% of their portfolio. If a tail risk strategy is employed successfully, it should cause an investor's portfolio returns to be at or close to flat when a tail event occurs. The tail risk fund should post enormous returns, wiping out the deep negative returns posted by the rest of the portfolio.

See the full ebook here.